The best definition of inflation is “a loss of purchasing power.” When inflation hits, your dollar doesn’t stretch as far, and the cost of most goods and services goes up.
As a result, the classic economic “basket-of-goods” gauge will indicate the cost of living as more expensive. You’ll most likely have to reassess your budget if things are already a bit tight, which for many, they are.
The Two Inflation Gauges
In the United States, two gauges measure inflation.
The C.P.I. – or Consumer Price Index – measures the average change in price over time of a basket of goods and services. For the essential items we consume, the C.P.I. shows a very tangible and apparent increase in price.
The second gauge is the P.C.E. – or Personal Consumption Expenditures Index. It is a United States-wide indicator of the average increase in prices for all domestic personal consumption. But whereas the C.P.I. focuses more on the basket of goods, the PCE measures everything we spend money on, including indirect payments like health care.
The Federal Reserve
The Federal Reserve, which is the central bank of America, ensures that prices don’t increase too quickly or by too much. This is vital for our economic stability, especially given the inevitability of inflation.
A small amount of consumer price inflation is healthy and normal: businesses must adjust to changes in the economy and scale their offerings accordingly. A 2% annual increase is considered acceptable, but anything over that, and consumers start to worry about their economic stability.
The Causes of Inflation
While some economists might argue that there are a wide variety of causes of inflation, there are three primary drivers. The first is demand-pull inflation, where the number of products and services available cannot keep up with the demand for those products and services, causing prices to increase.
Another cause is referred to as cost-push inflation, where businesses experience a rising cost of producing goods and services. In turn, they have to raise their prices.
Finally, built-in inflation, also called the “wage-price spiral”, happens when workers push for higher wages to meet the higher cost of living expenses. This drives businesses to increase prices to offset higher wage costs. The effect is a cyclical increase in both wages and prices.
Geopolitical issues, supply chain problems, and many other factors can also come into play, exacerbating inflation.
Is Inflation a Good or Bad Thing?
As mentioned, inflation is a normal part of the economy; problems only arise when prices increase too quickly and by too much. Hyperinflation is a dangerous trend that can create poverty, destabilize governments, and even result in political turmoil and war. But such extreme cases occur very rarely.
When inflation rises slightly above the recommended percentages, it can be a boon for people who owe money at fixed interest rates, especially small business owners. They’re paying back loans at the same fixed rate, but now they can sell their products and services for more money.
However, inflation can hurt many people, including lenders and people with low-interest-bearing savings. People living paycheck-to-paycheck also feel the pinch during periods of inflation as they have no monetary buffer and have less flexibility in their budgets.
Inflation is unavoidable. But maintaining responsible financial habits like budgeting, saving, and living within your means will help counteract the potentially harmful consequences of inflation.